Fed: Eyes on the Prize

Published on February 9, 2021
SGH Insight
There is a shared “eyes on the prize” between the Fed and Treasury to foster a high-pressure economy through an amply accommodative monetary policy underpinning an aggressive fiscal policy. We expect Chairman Powell will keep a newly unified Fed messaging firmly on a distant outcomes-based policy path through any stronger than expected near term growth. That means the Fed will “look through” an expected pop in measured inflation this spring or a continued rise in inflation expectations, and will push back against hawkish market pricing doubting the central bank’s current balance sheet and rates policy stance.
Market Validation
Policy Validation

FT 2/10/21

Jay Powell stressed the importance of “patiently accommodative” monetary policy to support the struggling US labour market, warning that achieving full employment in the world’s largest economy will not be easy. In prepared remarks to the Economic Club of New York on Wednesday, the chair of the Federal Reserve said US employment was far from its pre-pandemic level. He did not reveal any anxiety about a rise in inflation later this year triggered by President Joe Biden’s $1.9tn fiscal stimulus plan. “Despite the surprising speed of recovery early on, we are still very far from a strong labour market whose benefits are broadly shared,” Powell said. “Employment in January of this year was nearly 10m below its February 2020 level, a greater shortfall than the worst of the Great Recession’s aftermath.” Powell also indicated that US policymakers, including health officials, fiscal authorities and central bankers, would still have plenty of work to do in order to close that gap, suggesting the Fed did not see a quick end in sight to the economic downturn triggered by the pandemic.

Against the backdrop of reflation trades lifting bond yields and nudging inflation expectations higher, markets will be looking for any new signals or fine tuning to the Federal Reserve’s near term policy guidance in Federal Reserve Chairman Jerome Powell’s virtual remarks before the Economic Club of New York tomorrow afternoon on “The State of the US Labor Market.”

** Chairman Powell will no doubt talk up the likelihood for a strong rebound in growth that should pull unemployment lower in the second half of this year. But he will also note the nearer term outlook is still tempered with downside risk, citing longer term scarring risks in a labor market weakened by a falling participation rate and the wide dispersion in the unemployment rates among women and minorities. More to the point, we think Chairman Powell will reaffirm that hitting the mark on “substantial further progress” towards maximum employment will require continued and considerable monetary and fiscal policy support.

** In other words, there is a shared “eyes on the prize” between the Fed and Treasury to foster a high-pressure economy through an amply accommodative monetary policy underpinning an aggressive fiscal policy. We expect Chairman Powell will keep a newly unified Fed messaging firmly on a distant outcomes-based policy path through any stronger than expected near term growth. That means the Fed will “look through” an expected pop in measured inflation this spring or a continued rise in inflation expectations, and will push back against hawkish market pricing doubting the central bank’s current balance sheet and rates policy stance.

** That policy messaging discipline should hold through the coming months, but may prove more problematic in the second half of the year. Inflation may persist rather than ebb, for instance, especially if inflation expectations become even modestly more unanchored. But the biggest challenge to the Fed’s dovish path could come in further rises in asset price inflation, excessive risk taking, and financial market dislocations. But in the near term, the financial stability debate is not part of the policy calculation, and we suspect the Chairman will punt on the issue tomorrow.

The State of the Labor Market

In his remarks tomorrow, it would be surprising if Chairman Powell did not affirm the widely held expectations for a robust rebound in US growth that should start to gather steam by spring and perhaps even hit double digits as early as Q2 of this year. It would obviously be welcomed as a testimony to the resilience of the US economy and US workers.

But we expect Chairman Powell will also argue last Friday’s January nonfarm payrolls report pointed to a labor market growth stalling out. The decline in the unemployment rate is only because of the falling participation rate, especially among women; there are still nearly some 10 million people out of work since last February before the Covid storm, and in the last three months, net job gains are still shy of 30,000 a month, or around a third at best of what would be needed each month just to keep up with population growth and young entrants into the labor force.

More to a point we suspect will be a key takeaway of his speech, the Chairman may also note that even with the widely anticipated rebound in economic growth — herd immunity through mass vaccinations finally kicking in to unleash forced savings and driving a rush of repressed spending – the repair to the labor market is still in danger of a slower than necessary recovery if there is no substantial policy support.

The aim in policy, then, is not just to foster the conditions for a return of the millions of unemployed back to the work force, but to grow the labor market by even more, to stir a sustained growth in aggregate demand, and hopefully capital investment, to propel jobs growth into next year to get to maximum employment, and higher wages, as quickly as possible.

We are not sure the market fully appreciates the significance of the shift in the Fed’s reaction function and what it means to how it will respond to the stronger data that is hopefully coming around the corner. The old Fed, the Fed as recently as the period of the policy normalization strategy launched in late 2015, would worry over the market questioning its credibility to contain inflation and respond to strong data and forecasted higher inflation with a pre-emptive tightening through hawkish messaging or bringing rate dots forward in the Summary of Economic Projections. But that is just not the case under the new regime put in place last August.

“Overshooting is Better Than Undershooting”

“Overshooting is better than undershooting,” Federal Reserve Bank of Chicago President Charlie Evan asserted last week when asked about the Biden Administration’s fiscal policy proposals. “If it’s too much, I think we can live with that…doing more is better than doing less in the current situation.” It neatly captures the thrust of the Fed’s new policy framework.

And if it sounds an awful lot like Treasury Secretary Janet Yellen’s repeated case made when she hit the Sunday talk shows last weekend for a “big package done quickly,” it is because there is a shared policy lessons drawn from the sub-par recovery in the wake of the 2008-2009 crisis. “There’s “no reason why we should suffer a long, slow recovery,” Yellen said in her remarks on Sunday, and on that score, Chairman Powell would more or less say the same thing.

Much of this policy approach being adopted by the Fed and so many former Fed officials now at Treasury and shared across the incoming Biden Administration is likewise drawn from the policy recommendations in a seminal paper written by three Fed staffers in 2013. In the paper, “Aggregate Supply in the United States: Recent Developments and Implications for the Conduct of  Monetary Policy,” the Board staff argued the merits of an aggressive monetary (and fiscal) policy response to limit the damage to potential output and trend growth in a prolonged period of high unemployment, weak demand, and under-investment. Demand, if amped up early enough and in scale, could create its own supply with higher capital investment and a rising labor participation rate.

It is a similar logic to the aggressive and swift slashing of rates laid out in the so-called Reifschneider-Williams playbook to maximize the policy punch when so near the constraints of the effective lower bound in the face of an impending recession (see SGH 9/26/19, “Fed: Disparate Perspectives), which is exactly what the Fed did in March.

In the current circumstance, the Covid pandemic has not only devastated large swathes of the high personal contact sectors of the economy, driving unemployment to still extremely high levels, but if allowed to run for too long without further substantial policy support, it could weaken and even reduce potential output and lead to an even lower labor participation rate. And while Chairman Powell may not necessarily lay out such a strongly made case tomorrow, for now the FOMC consensus is that caution can prove to be even more costly than a speed and scale to the monetary and fiscal policy response.

Message Sequencing

One last point: while it would be hard not to notice the flush of common buzzwords in a newly unified policy messaging across the first round of public remarks by Committee members in the days since their January meeting —  policy is in a “good place,” a “good spot,” a “bridge” and “staying the course for a while” – our  sense is that the change in tone and the newfound alignments of policy guidance has less to do with any strong arm messaging discipline being imposed by the Chairman as much to do with a Committee consensus on the centrality of sequencing the policy communications.

A first testing of the new reaction function may inevitably come as soon as this spring when growth and job creation should be gathering considerable momentum, assuming the Covid infections are brought under control. But the real challenge to the credibility of the Fed’s dovish reaction function is more likely to come later in the year, and there will be plenty of time, and policy space, then to offer alternative considerations, highlight other risks, or even to dissent.

Until then, when there is in fact so little near term prospect of changes in rates or balance sheet policy, picking the timing of your battles can be just as or more important than choosing which battle is to be fought.

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